Big Things Happening In Japan

Japan is still the place where the biggest changes are happening on the margin. Stocks are still soaring as the yen falls, and now Japanese bond yields are soaring as well. Quantitative easing in Japan, which involves massive purchases of JGBs, has produced the counter-intuitive result: sharply lower bond prices. That's a good indication that monetary ease is working.

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The strong inverse correlation between the yen and the Japanese stock market is a predictable result of monetary stimulus that reverses deflationary pressures that had been generated by the yen's relentless climb against all other currencies.

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The chart above shows the yield on 10-year Japanese government bonds (JGBs). Note that yields are now higher than they were when the BoJ announced last November its intention to start buying lots of bonds. Yields fell for several months, but in the past few days they have soared as the market begins to realize that monetary stimulus designed to get rid of deflation, coupled with the promise of fiscal stimulus and other growth-oriented reforms, have already managed to stimulate the economy. As Bloomberg notes in a recent release:

Prime Minister Shinzo Abe's stimulus probably helped the Japanese economy grow the most in a year, adding to pressure on 2013's worst-performing bond market. Gross domestic product likely expanded an annualized 2.7 percent in the three months through March... Japanese bonds declined 14 percent in dollar terms this year... Inflation expectations rose to the most since at least 2009. Abe's push for monetary and fiscal stimulus to overcome more than a decade of deflation is invigorating demand among consumers... The economic rebound is also spurring expectations that consumer prices will increase as the yen tumbles, causing bond yields to surge in spite of a doubling of debt purchases under BoJ Governor Haruhiko Kuroda. Consumer sentiment is improving and consumption is gathering steam at an unexpectedly rapid pace...

In short, to be effective, monetary stimulus must achieve the opposite of its stated goal, which is to reduce interest rates. Rising interest rates go hand in hand with stronger growth and rising inflation expectations.

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The same scenario, but to a lesser degree, is now playing out in the U.S. As the above chart of 10-year Treasury yields shows, yields are now higher than they were when the Fed announced its QE3 program in September, and when they increased the size of monthly purchases last December. Yields are up despite concerted buying by the Fed because the market is raising its expectations of U.S. growth.

This is also a good illustration of my long-held view that the Fed cannot artificially manipulate interest rates. Treasury yields have been very low not because of Fed bond purchases, but because the market was very pessimistic about the prospects for economic growth. Rates are now moving higher despite ongoing Fed purchases because the market is adjusting upwards its expectations for growth.

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The above chart attempts to show how real yields on TIPS tend to track the underlying growth potential of the U.S. economy. When the economy was booming in the late 1990s, TIPS real yields were about 4%. But in recent years economic growth has moderated significantly, and real yields have fallen. The recent increase in five-year TIPS yields doesn't look like much in this chart, but it has been on the order of almost 60 bps, and that is significant. Despite the recent increase, the current level of TIPS yields is still consistent, I think, with a market that holds little hope for any meaningful economic growth in the years to come.

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